Relevant or alternative cost analysis is a management accounting technique that helps managers decide between different courses of action. Also known as differential analysis, this technique relies upon management only considering costs and revenues that differ between alternatives. Understanding how to leverage relevant cost analysis in your company can help you take the most profitable course of action.

Make or Buy

Relevant cost analysis is used when companies determine whether to make or buy a product. For example, a bakery may receive an outside offer to produce apple turnovers for the bakery to sell. Just looking at the numbers, the company should only consider the costs that differ between the two decision choices. If the company chooses to continuing making the turnovers in house, the manager should consider the costs of materials, labor and the overhead that is specific to turnover production. If the company buys the turnovers, the manager needs to consider the cost of paying the producer and any reductions in cost, if any. Looking at the finances of the situation is important, but small-business owners should consider qualitative costs as well, such as the impact on product quality and effects on the bakery's reputation.

Accepting Special Orders

Your best customers often are the ones who demand the lowest prices. Small-business owners can use relevant cost analysis to determine if they should accept special pricing for orders. The key to this analysis is capacity. If your company has excess capacity to fulfill a special order without sacrificing other customer orders, you only need to consider the incremental costs and revenues associated with the order. In many cases, this means that if the sales price per unit is greater than the materials, labor and variable overhead per unit, the special order will be profitable.

Discontinue a Product

Unfortunately, not every product is a slam dunk. Relevant cost analysis is often used by company management to determine whether it's time to cut losses and discontinue a product or business segment. To do so, management will prepare one income statement that includes keeping the product and one income statement that assumes discontinuing the product. For each item on the income statement, the company determines if the income or cost item will change under the two scenarios. After this process is complete, the company will determine if overall company profit is greater under one of the two scenarios and should choose the one with the greatest profit.

Sell or Process Further

Small-business manufacturers may be faced with deciding whether to process a good further or sell the good at an early point. For example, a potato farmer needs to decide what form of potato to sell. The farmer could sell raw potatoes, process the potatoes into washed and quartered potatoes or process further into french fries. Relevant cost analysis is used to make this decision. Once a manager gets to a point where the product can be sold or processed further, the manager should determine the cost of further processing and the incremental revenue. Using the potato example, if the farmer could sell raw potatoes for $2 per pound and it would cost $1 per pound to process potatoes into hash browns, the farmer should not process further unless the price of hash browns was $3 per pound or greater.

About the Author

John Freedman's articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public company auditing and work with the campus recruiting team for his alma mater.